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pension accounting

You’ve got to be a bit of a geek to love investing. One reason is the math–there’s lots of it. Another reason is that you should enjoy digging through obscure footnotes to financial statements. Most people would rather get a root canal than read such arcana.

I, however, am a big fan.

An area that will soon get big attention is pension accounting. You must dig into footnotes to see this information, and it’s not a pretty picture.

When organizations, whether governments or companies, report their financial situation, they must disclose how much they owe employees through pensions. Like all accounting information, this is based on assumptions. One key assumption–that’s way off base–is return on assets.

An organization that owes money to employee pensions must estimate how much they need to pay out and how much return they’ll get on assets to make those payments. If they assume lower future payments or high returns on assets, then their pension liability magically shrinks! And you thought Santa was good…

Not surprisingly, most companies and public pensions are making flattering assumptions to make their financial statements look better.

As a simple example, most companies I research (with pensions) assume they’ll get 8% returns on assets. That may not sound ambitious to you, but it is. Bonds will probably provide 4% returns from here and stocks will return around 6%. Assume a pension has a standard 60% equity/40% bond allocation, and you get a whopping 5.2% return.

So, most companies and governments are under-reporting pension liabilities by around 33%. This will be difficult for many companies, but they will get by (although shareholders will be less sanguine). Public pensions, however, will be a nightmare.

Another fact unknown to most is that governments have a different set of accounting rules than companies. Whereas companies have strict rules about accounting for and allocating assets to pensions, government bodies are much more lax (pay as you go, easier assumptions).

I was reminded of this recently when talking to a lobbyist who works for our local power company. I asked him if the utility would be bought by a company or taken private, and he said he didn’t think anyone would buy it because they would have to account for pensions differently, and that would wipe out the value of the utility company. Wow!

Now, picture that occurring all across America. Most public pensions are grossly under-reporting pension liabilities, and they are in trouble even before reporting that huge liability accurately!

This will make big news at some point, probably within the next 2 to 3 years. The cause will be interest rates rising (thus decimating bond values) or a big decline in equity prices (hitting pension assets from the other side).

Mark my words: pensions will cause real pain to shareholders and major pain to state and local governments (which means taxpayers).

Just when you thought it was safe to go back in the water…

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.